Tipping Points: Profits and Currency

The direction of corporate profits and the US dollar are at critical points. Soon, we learn about the future direction of a range of financial markets.

There are two charts at http://www.thebigpicture.com.au/atc/tipping_point.pdf. The first shows the quarterly history of US corporate profits since 1988. The yellow line is the after tax profit series reported in the national accounts by the US Bureau of Economic Analysis. The blue line is the better known earnings series of S&P 500 companies. The red markers are analysts' forecasts for the S&P 500 companies over the coming two years.

Both profit series highlight the same three visually striking features.

The very sharp decline in 2008 when S&P 500 earnings were eliminated briefly.

The rapid earnings recovery once the worst of the global credit crisis was over.

The apparent loss of momentum once the pre crisis level of profitability had been reached again.

The critical question now is 'where to from here?'. Extrapolating the most recent experience might suggest a lacklustre outcome over the coming year. The bottom up earnings forecasts from the stock analysts, on the other hand, are suggesting that recovery will gave way to an earnings expansion that would validate a continuing rise in US equity prices.

The second chart shows the history of the US dollar since 1973. This measure of the US dollar is an index calculated by the US Federal Reserve for the value of the dollar against a basket of seven major currencies. Again, three features of the series are visually striking.

Despite the focus on more recent evidence for its decline, the US dollar has been in a downtrend for nearly 40 years. (Perhaps this is the lot of a currency that is responsible for lubricating world trade. Its supply must increase in line with global needs not domestic requirements. The prestige is good to have but there is a less desirable downside.)

Even within the context of a downwardly trading currency, there are can be prolonged periods during which it rises.

The fall in the value of the currency over the last six months has taken it back to the level that was reached in the second quarter of 2008 before people realized that the credit crisis was not confined to the USA. There has been no significant net downward movement since then.

Extrapolating both the most recent experience and the long term trend in the currency would suggest continuing weakness in the dollar exchange rate. However, the current position of the dollar, and its trading pattern since 2008, is also consistent with a flattening in its trajectory and, perhaps, in due course a trend reversal, too.

The currency has a link to corporate profits. The weaker dollar is helping to boost earnings, especially among the large number of S&P 500 companies now operating outside the USA. A currency reversal would throw into doubt the current earnings forecasts and the anticipated equity market upside implied by those expectations.

The direction of the dollar will also have a material impact on the prices of US dollar denominated commodities. A stronger dollar will sap their recent strength. A weaker dollar will reinforce the sustainability of strong commodity prices.

There is another reason for suggesting markets are on the verge of a tipping point. The US Federal Reserve's current program of quantitative easing is set to finish in June. Before then, members of the FOMC will have to address how they prepare the markets for a decision to stop or extend the program.

Even if the committee decides not to extend the securities purchasing program, it will have to address questions about the transition to a new policy setting. For example, how much of the interest income from existing security holdings and the proceeds of maturing securities will be used for fresh security purchases?

The point of these notes is not to offer a forecast for earnings, exchange rates or monetary policy. The point is to highlight how we appear to have reached a series of tipping points across a wide front.

Whether these measures of economic performance move up or down or remain unchanged in the next few weeks, we will not have long to wait to learn something about the future direction of a range of financial markets.

If you liked this article and would like more by email, subscribe! It's free.

[Bold fields are required]

Your details

Your alternate email address is used only if messages to your primary email address are returned to us.

Mailing addressEmailAlternate emailFirst nameLast name

Industry

Do you work in the financial services industry?

Yes No

This email is general in nature only and does not constitute or convey specific or professional advice. Legislation changes may occur quickly. Formal advice should be sought before acting in any of the areas discussed. Be aware that the information in these articles may become innaccurate with time. Responsibility is disclaimed for any inaccuracies, errors or omissions. Particular investments are neither invited nor recommended and hence this publication is not "financial product advice" as defined in Section 766B of the above legislation. All expressions of opinion by contributors are published on the basis that they are not to be regarded as expressing the official opinion of any other person or entity unless expressly stated. No responsibility for the accuracy of the opinions or information contained in the contributor's articles is accepted by any other person or entity.
Copyright: This publication is copyright. If you wish to reproduce this article you require a license, which can be purchased here, to do so.